Audit

Happy Tuesday! As of August 15, 2011, we now have a reported tax case arising from the infamous ClassicStar debacle. Not surprisingly, the precedent involves "bad facts" and is not helpful for other taxpayers who took part in a ClassicStar deal or similar deal. The following guest post on the opinion, entitled Van Wickler v. Commissioner, is by Paul Husband, a California equine lawyer whose practice emphasizes tax matters. Enjoy!

"ClassicStar LLC was a company which offered highly leveraged mare leasing deals. They offered top quality Thoroughbred mares and stallion breeding rights to leading sires like Elusive Quality and Mineshaft. The tax benefits of their programs, turbo-charged with leverage provided by loans which they helped arrange were prodigious. Leveraged mare leasing combined with the expensing of stud fees and the expensing of certain prepaid expenses can generate very significant tax savings. Unfortunately, the principals of this company ended up in prison for fraud.

But the fraud was not based on invalidity of the income tax law principles related to mare leasing and horse breeding which were involved. Rather, the fraud involved misrepresentations concerning facts of various sorts, such as the “high quality Thoroughbred” mares, who sometimes turned out not to be Thoroughbreds at all, but Quarter Horses, or grade horses. The ClassicStar program also suffered problems in some cases with the reasonableness of charges, such as, a lease fee of over $200,000 which was charged for a mare which sold for $350.

There were hundreds of IRS audits of individuals who did business with ClassicStar. There were hundreds of assessments by the IRS based on these audits, and hundreds of Tax Court petitions were filed. Now we have a reported decision.

But, horse breeders lose Tax Court cases based on the “hobby loss” rules of Internal Revenue Code Section 183 all the time. Why should we care about this one? We should care because this precedent may be used as a bludgeon against others who did business with ClassicStar, even if the facts of the later cases were very different than the facts in Van Wickler. This reported opinion reflects a conscious policy by the Internal Revenue Service to “manage” case law. The IRS wants case law which is favorable for them. Favorable precedents give IRS Appeals Officers greater leverage in discussing settlements with horse business owning taxpayers and/or their representatives.

The nature of the facts varies enormously in the hundreds of ClassicStar cases pending across the United States from cases in which the horse leasing taxpayers had very strong facts, and would likely win at trial, to cases such as Van Wickler. The facts in Van Wickler constituted a parade of horribles. In it, the taxpayer:

1. Signed an agreement purporting to be the managing member of an LLC that had not yet been formed;

2. Backdated a board agreement to November 1, 2002, when he did not enter into the transaction until December 30, 2002; and

3. Signed a lease in which the schedule setting forth the names of mares to be leased and stallions whose breeding rights would be used was blank – the taxpayer did not know the identities, or even the breed of the mares which he had allegedly leased.

The Tax Court in Van Wickler found:

1. The accountings submitted to the court were contradictory and varied from version to version; and based on them, neither the taxpayer nor the Court could tell how much money was spent, or what it was spent on.

2. The taxpayer not only did not negotiate the contract terms, he did not even know what the contract terms were.

3. The taxpayer could not tell what horses had been leased.

4. The mare named “Lita May” sold for $350, but one chart showed that the lease fee for her was $260,723, and on a different chart, the lease fee for that same mare was shown as $185,000.

The Court held that there was no basis in the record to determine which expenses were allowable and which were not. Therefore Court concluded that there could not be any expenses allowed as deductions.

Yet there was some mercy shown. The Court found that Van Wickler had relied on an independent C.P.A., who had been deceived by the promoters, and who advised Van Wickler that the ClassicStar deal had a high degree of risk, but could have a high return. Based on what the court perceived as good faith efforts to get professional advice and his reliance upon a C.P.A., no penalties were assessed.

The fact that Van Wickler is a reported case reflects that the IRS is judicious in managing their caseload. It was the Van Wickler case, with terrible facts for the taxpayer, that was tried and reported, rather than a case with good facts for the taxpayer.

By contrast, in 2009, the IRS had another ClassicStar case in Tax Court which the mares leased were identified and were high quality Thoroughbreds; where the taxpayers were actively involved in managing their business, and had made visits to the farm where the mares were boarded, and to the auctions, had taken extensive horse business education, and had good books and records. The taxpayers had a highly qualified expert witness and your writer as an attorney. In that case, the IRS conceded shortly before trial. It was obvious that they did not wish that case to be the first judicial precedent for ClassicStar breeders.

Make no mistake, I favor concessions by the IRS when it is obvious to them that the taxpayer is going to win the case. But my point is that as practitioners and horsemen and horsewomen, we should not be overwhelmed when case law like Van Wickler is brandished by an IRS Revenue Agent, Appeals Officer or District Counsel lawyer. They do pick and choose their cases, and therefore, often the judicial opinions come out of cases which are factually favorable for the IRS. These opinions do not mean that cases with facts favorable to the taxpayer/horseperson cannot be won. The individual facts of each case are paramount in determining the outcome of cases such as the ClassicStar cases. Representatives and horsemen should not be cowed into submission by an IRS reference to the Van Wickler decision."

There is a sense among equine tax professionals and tax lawyers that as of recently, IRS has begun to audit more horse businesses than ever before, and that the IRS is allowing fewer deductions and losses for taxpayers who run horse businesses.

If your horse business is audited, your first call should be to your accountant, who can advise you how you should handle yourself and your paperwork during the audit. However, once your audit begins, there is often little your accountant or lawyer can do to influence the auditor’s decision about what is contained in your business records. Thus, it is highly important that you take steps in advance (beginning with the first day you start running your horse business) to stave off an audit, or at least end up with a “no change” audit (i.e. a finding by the auditor that you reported everything correctly).

Jim Hodges is a certified public accountant (CPA) in Dallas, Texas who has over 30 years of experience preparing returns for horse businesses and horse owners, and has assisted many horse owners with audits. Here are Jim’s top 5 tax tips for horse businesses:

1) Draft a business plan that describes how you plan on making a profit in your horse business.

2) Keep very good business records, including records of the time you spend on your horse activity.

3) Hire a good bookkeeper to keep your books and records for your horse business.

4) Do not commingle personal funds and funds used for the horse business. Use separate bank accounts and credit cards.

5) If you have large losses from your horse business one year, it is tempting to deduct only part of the losses so it is not as much of a “red flag” to the IRS. DO NOT DO THIS. For all expenses or deductions for your horse business, you should take an “all or nothing” approach.

**I (Alison) put together a sample business plan for horse businesses (for a fictional business), and it can be downloaded here. For more information on equine business plans, see this post.**

The sense I get from talking to many with their “ears to the tracks” on audits is that if you make a lot of money in your “day job”, you are likely to get audited, even if you are doing everything correctly. Similarly, if you write off large losses, you are likely to be audited, even if you did not do anything inappropriate. But as long as you are legitimately running your horse operation “like a business”, you are likely to survive an audit.

About Alison

Alison is recognized nationally as a top expert in the area of equine law. Alison’s equine industry focus involves providing professional assistance and legal representation to individuals, business entities, associations, government agencies and legislative bodies who are involved in the horse industry.